For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

Risk is a relative term. If someone asked you to set aside $150 a month, possibly with no return on your investment, you’d probably say, “No way!” Yet what if you knew the alternative was losing your home and all of your belongings in a fire, flood, or other emergency, with no funds to help rebuild your life? Suddenly, the $150-per-month payment for disaster insurance might seem like a good idea.

The same perspective can apply to bonds. If you’re considering an allocation to bonds but have been warned that this allocation may have low or even negative returns in the next few years, you may see bonds as a risky bet. Yet by weighing the risks of the alternative—that an allocation to equities is far more likely to experience highly negative returns of –5% or more during the same period according to output from Vanguard’s Capital Markets Model—you may begin to recognize bonds as the steady diversifier and volatility dampener they truly are when combined with a stock portfolio.

The calculation of bond returns is highly mathematical in nature, and right now the equation isn’t pretty. Output from the Vanguard Capital Markets Model® (VCMM)* suggests that the most likely annualized return scenario for bonds over the next ten years will be in the range of 1.5% to 2.5%. This is considerably lower than the long-term historical average** for bonds of 5.6% through the end of 2012. This disappointing bond performance may be a rude awakening for clients coming off the 30-year bond bull market.

However, before abandoning bonds in search of higher-yielding securities or those with greater potential for returns, you should consider the corresponding risks. In the chart below, you’ll see that, when considering the relative risks of bonds and equities, in addition to the issue of whether these asset classes face a risk of loss, you must consider the potential magnitude of the loss. While bonds may have a higher probability of low or negative returns over the next few years, they have a relatively low risk of experiencing the magnitude of losses equities are susceptible to. In the rolling 12-month periods shown below, there were 211 instances when equities saw returns of –5% or less but only 30 instances when bonds had losses of the same magnitude.***

Relative risk of loss in equities and bonds over a rolling 12-month periods

Notes: Returns are year over year presented on a monthly basis.Source: Vanguard. For U.S. bond market returns, we used the S&P High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975, and the Barclays U.S. Aggregate Bond Index thereafter. For U.S. stock market returns, we used the S&P 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter.

In addition to lessening the potential losses in an equity portfolio, bonds have other properties that make them a good diversifier. In Reducing bonds? Proceed with caution, Fran Kinniry and Brian Scott conclude that bonds’ low correlation with equities means they will likely continue to provide a cushion in periods of negative equity returns. The slightly negative or slightly positive returns from your bond allocation, while nothing to write home about in terms of income generation, should help cushion portfolio losses in a poor equity market. Compare this soft landing with a portfolio that has substituted assets such as high-dividend stocks, REITs, and high-yield bonds for traditional bonds in search for yield. As the chart below shows, such asset classes have experienced relatively large losses before, particularly during the tumultuous equity bear market from October 2007 to March 2009, diminishing their diversification potential when it was needed most.

Of course, bonds may not offer the same level of protection as they did in the past. We likely won’t see the 15% returns in Treasury bonds that appear in the above chart anytime soon.

But remember that this potential disappointment is merely relative: The cushion may not be as deep as before, yet you would likely prefer the reality of underperforming bonds to a world in which all asset classes in their portfolios moved down at the same time and by a similar magnitude. For that reason, Vanguard still believes in the diversification value that bonds provide investors during rough periods of equity returns.

____________________________________________________________________________________________________
*Historical series of asset class returns and economic variables serve as inputs for the VCMM, which then uses the current conditions of these variables along with their modeled interrelationships to provide users with 10,000 potential paths for the returns of several asset classes under various economic conditions.
**Long-term returns are the average monthly U.S. aggregate bond market annualized returns since 1926. In defining the aggregate U.S. bond market, we used the Standard & Poor’s High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and the Barclays U.S. Aggregate Bond Index thereafter.
***In defining the U.S. stock market, we used the Standard & Poor’s 90 from 1926 through March 1957; the Standard & Poor’s 500 from April 1957 through 1974; the Dow Jones Wilshire 5000 from 1975 through April 2005; and the MSCI Broad Market Index thereafter.

Notes:

Investments in bonds are subject to interest rate, credit, and inflation risk.

Past performance is no guarantee of future returns.

All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then

Joe Davis

Joe is Vanguard's global chief economist and head of Vanguard Investment Strategy Group. He's also a member of the senior portfolio management team in Vanguard Fixed Income Group. Joe's global research team is responsible for overseeing Vanguard's investment methodologies and asset allocation strategies for both institutional and individual investors. They also provide thought leadership on a broad range of investment topics, including the capital markets, the global economy, and portfolio construction. In 2004, Joe was selected as a faculty research fellow at the National Bureau of Economic Research for his contributions to the fields of economic history and U.S. business cycles. Before joining Vanguard, Joe spent time as an economist at Moody’s Analytics. Joe earned his M.A. and Ph.D. in economics at Duke University.

Comments

Charles T. | December 28, 2013 6:16 pm

The last 10 years have been as wild a time for stock fund investors as any in history. There have been two major dips followed by two major bounces. Yet at at the end of the 10 years, I have more money than at the start – and I had to withdraw money each year for living expenses. How can this be?
It turns out that when in retirement we feed in money in small annual chunks (investment earnings) and take money out in small annual chunks (distributions). As long as the big dips are followed by big bounces, we do all right. And such has been the case for at least the last 80 years. On average, I’ve done much better in stocks than I have in bonds.
So: If you can stand the heat, why invest in bonds at all?

Mr. D. | November 18, 2013 8:55 am

Call me risk adverse. Bonds, whether indexed, individual or through a vehicle
such as a fixed income desk can erode from inflation. Try to imagine the lucky
soul reaping the rewards after a long term 30 year bond matures.
Target retirement funds pushed through be congress can be risky (2010) ,
cash is related to the dollar’s value and indexed bonds I shy away from.
Some of the best bonds I own are EE bonds, I bonds purchased as a young man
before Treasury was” Direct “. If I become a centurion, maybe then the satisfaction
of “high interest” and return on the dollar will be right up there with chocolate
pudding

Bev M. | November 8, 2013 12:07 am

This is one of the best articles I’ve read regarding Bonds. A picture is worth a thousand words and this article is short and sweet. Facts and data avoids the fear and sets the expectation. Thanks Vanguard for all you do.

Paul W. | November 6, 2013 10:24 am

I think the equities as alternate is not appropriate comparison. I agree we all need a cushion against falling stocks, but Why Bonds? Right now there is very little upside to bonds and definite losses to come when rates rise. It would seem that the near zero return on cash is the best place now for the “insurance” against a fall.

Oran L. | November 4, 2013 4:56 pm

Given that I’m a conspiracy theorist, why would the “government” raise rates when this would increase the deficit, raise the SS increase, raise a host of things tied to the inflation rate. Weaken the stock market et al. This is to say I believe all the numbers are artificially controlled. Any comments to this theory?

Tom H. | October 28, 2013 10:32 am

Paul,
I thought that the statement “you would likely prefer the reality of underperforming bonds to a world in which all asset classes in their portfolios moved down at the same time and by a similar magnitude” seems to go against the wisdom of buy and hold. Why not look at the 5 year or ten year cumulative returns of a fund or etf rather than a down 1 1/2 year period? Lets’ compare a ‘balanced’ portfolio of say 50-50 bond-stocks over a five or ten year period that included the 2007-2009 period against an aggressive stock or high yield bond fund fund and let the chips fall where they may. Of course the returns should be cumulative.

Dennis O S. | October 20, 2013 11:46 pm

Paul D. | October 10, 2013 12:39 pm

During troubling times like these (especially with the uncertainty of the gov’t. shutdown), having an adequate cash cushion is, in my opinion, crucial. A portfolio is like a three legged stool where stocks, bonds, and cash serve to ‘balance’ each other so everything doesn’t come tumbling down.

I think it is of vital importance for folks to have at least 3-6 months living expenses ALL the time…separate from that three legged portfolio. Cash is the greatest lifeboat you can have…giving you the flexibility to wait out whatever storm is on the horizon.

However, cash will not protect you from inflation. But, if you have enough cash to enable you to wait until your usual investment vehicles return to some form of ‘normalcy’, you can always reinvest any excess cash.

Richie W. | November 19, 2013 12:14 pm

I’m 67, retired this year, 100 % invested in Vanguard mutual funds. All the funds have performed well however, I need to know of at least three bond funds that Vanguard offers that offer safety of principle and give some present return.
Any suggestions ?

Charles C. | October 10, 2013 11:07 am

Some sources will tell you that duration is a bigger risk than the risk of default.

What's your opinion?

Vanguard welcomes your feedback on this blog, but please read our commenting guidelines
first. Comments will be published at our discretion. Questions or comments about your Vanguard investments or customer-service issues? Please
contact Vanguard directly. Opinions expressed in blog comments are those of the persons submitting
the comments, and don't necessarily represent the views of Vanguard or its management.

You might like

Twitter

For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.